Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

Iceland—2012 Article IV Consultation Concluding Statement of the IMF Mission

March 2, 2012

Iceland has achieved much since the crisis and its economy is growing again. Nonetheless, considerable challenges remain. Tackling these will require steady policy implementation, increased coordination, and stronger policy frameworks.

Outlook and Risks

The outlook is for a moderate recovery. Over the medium-term, the drivers of growth will gradually shift away from domestic demand (notably investment) toward external demand (as exports increase). However, there are risks to this outlook, emanating from both external and domestic sources.

1. Iceland’s post-crisis recovery has taken hold. After two years of recession, growth turned positive in 2011, led by domestic demand. The labor market improved, although the unemployment rate remains high. Inflation picked up considerably, and remains a concern.

2. A moderate economic expansion is projected going forward. For 2012, growth is expected to be 2½ percent, led by investment and consumption (both of which should pick up from exceptionally low levels). The medium-term outlook is for moderate growth (2½-3 percent). The sources of growth will rebalance over time, away from investment (as projects are completed) and toward exports (as investment projects bear fruit). This should support job creation and facilitate a decline in unemployment. The output gap is expected to close in 2013. Headline inflation is projected to remain above the central bank’s target in 2012. Thereafter, inflation is projected to gradually come back down to target, reflecting tighter monetary policy.

3. The outlook is subject to considerable risks, both external and domestic.

  • External risks. The most significant risk arises from the possibility of a marked deterioration of conditions in Europe, with implications for Iceland through trade, market access, foreign direct investment, and commodity prices. The banking system should remain relatively sheltered given its minimal linkages with Europe, but any major shock to the economy could adversely affect the banking system through lower economic growth and an associated deterioration in asset quality.
  • Domestic risks. On the domestic side, possible delays to investment projects in the energy-intensive sector would affect growth immediately (through lower investment) and over the medium term (through lower exports). Uncertainty about the legal and business environment and about policies in key sectors could also weigh on investment. Further wage increases in excess of productivity gains could fuel inflation and erode export competitiveness. Deviations from Iceland’s strong policy performance in recent years could undermine confidence in its significant achievement to date.


Iceland’s policy implementation since the crisis has been impressive. Going forward, the challenge is to ensure that momentum is not lost and that policies are well coordinated.

Fiscal policy

4. The fiscal consolidation is continuing, but at slower pace than anticipated. Preliminary data suggest that expenditure overruns materialized in 2011, increasing the general government primary deficit to ¾ percent of GDP (½ percentage point worse than expected at the time of the last IMF mission). For 2012, the general government primary surplus is expected to reach 1½ percent of GDP (compared with an expected 2 percent of GDP). The mission is concerned about these deviations, especially in light of the considerable risks to the revenue projections in 2012 and the medium term. Moreover, there is a risk that expenditure overruns may appear again, which would also affect the medium-term fiscal path.

5. It is essential that fiscal adjustment be completed. After the slowing of consolidation in the authorities’ 2012 budget and medium-term framework (as agreed at the time of the last IMF mission), the scope for deviations from that framework is limited. Thus, additional measures are needed to reverse the projected slippage from the 2012 budget. Permanent measures of ½ percent of GDP will be needed in 2012 to ensure that the authorities’ fiscal objectives (overall balance in 2014 and a primary surplus of 5 percent of GDP by 2016) can be met. Contingency measures should also be identified in case implementation risks materialize. This will allow gross general government debt to decline from nearly 100 percent of GDP at end-2011 to around 80 percent of GDP at end-2016.

Monetary policy and capital controls

6. Monetary policy should be gradually tightened. With continued (and possibly rising) inflation pressures and with expectations consistently above the central bank’s inflation target, policy interest rates should rise. Monetary tightening will also be necessary to support the capital account liberalization.

7. Lifting capital controls remains a key challenge. With a large amount of locked in non-resident funds and significant pent-up demand by residents for foreign assets, capital account liberalization is one of Iceland’s overarching policy challenges. Against this background, a gradual approach to liberalization, as outlined in the authorities’ strategy, remains essential. The speed of capital account liberalization will depend critically on the strength of the balance of payments outlook, reserve adequacy, and the need to safeguard financial stability. In view of the uncertainty in the global environment, consideration should be given to a further extension of the capital controls, beyond end-2013.

Private sector debt restructuring

8. We welcome the progress on household and corporate debt restructuring, but are concerned about the prospect of new delays. Preliminary data suggest that over 80 percent of household and corporate applications for debt restructuring have been processed. However, the February 2012 Supreme Court ruling has increased uncertainty about how foreign exchange-indexed loans are to be recalculated. This may delay completion of the debt restructuring process and slow the economic recovery by prolonging uncertainty for households, corporations and banks about their financial positions.

9. Renewed calls for across the board write-downs of inflation-indexed debt or other general measures should be resisted. Such measures would be untargeted and would not fully address the problems of those most in need. Moreover, the high level of public debt severely constrains room for any new measures that are not financed through a reprioritization of expenditures or new revenue measures. In this regard, it is critical to ensure that Iceland’s public finances remain on a sustainable path and that its significant fiscal achievements are not undermined.

Financial sector

10. The three largest commercial banks have continued to strengthen their balance sheets. As of end-September 2011, average reported tier 1 capital rose to 21 percent of risk weighted assets (from 19 percent at end-December 2010). Corporate and household debt restructuring has reduced nonperforming loans (NPLs) to 23 percent (from almost 40 percent one year ago); deposits are gradually increasing; and liquidity is high. Banks’ loan portfolios are subject to semi-annual reviews by external auditors, banks are working toward adoption of Basel III liquidity ratios, and a recent FME assessment has confirmed that banks have made substantial reforms to their risk management systems.

11. Nevertheless, new risks and legacy vulnerabilities pose challenges. The latest Supreme Court ruling is likely to lead to further writedowns of foreign exchange-indexed loans, adversely affecting banks’ loan portfolios and capital positions, but banks expect the effect to be manageable. The ruling has also created new uncertainty about banks’ asset values. Moreover, additional rulings with negative implications for bank capital cannot be excluded. On legacy vulnerabilities, NPLs have declined but are still above healthy levels. More needs to be done to reduce bank imbalances, decrease deposit and loan concentration, enhance the solvency of the Housing Finance Fund (HFF), ensure long-term viability of non-systemic institutions, and strengthen the operational efficiency of financial institutions.

12. The progress on bank restructuring is commendable, and efforts to reduce vulnerabilities and boost confidence in the banking system must continue.

• Since fully addressing remaining risks and vulnerabilities will still take some time, banks will need to continue to hold high levels of capital. To this end, dividend payments should be prevented until vulnerabilities have been sufficiently reduced.

  • Confidence in banks—a precondition lifting capital controls—would be further strengthened through greater transparency on the part of banks regarding the level of restructured loans, the impact of income recognition policies on profits, and the adequacy of existing buffers to cover unexpected losses.
  • The FME, for its part, should continue to ensure that banks are following prudent policies on income recognition, asset valuation, stress testing, and contingency planning. It should also work with banks on a strategy for disclosing ICAAP results.

Strengthening Frameworks

Since the crisis, there has been considerable progress in strengthening the frameworks for fiscal policy, monetary policy, and financial sector supervision. But more remains to be done to consolidate the progress and underpin a sustainable medium term recovery.

13. Fiscal framework. The mission welcomes the passage in September of the Local Government Act, which will strengthen local government finances. The authorities have also proactively identified weaknesses in Iceland’s budgetary framework, which need to be addressed in order to ensure that there are adequate controls over budget process and implementation. The authorities’ intention to submit to parliament new legislation on public finances, drawing on IMF technical assistance relating to organic budget laws, is therefore most welcome.

14. Monetary policy framework. Iceland should focus in the near term on strengthening the existing framework for monetary policymaking. This could include introducing macroprudential tools to help insulate the domestic economy from volatile capital flows and improve the traction of monetary policy. Moreover, better coordination between monetary and fiscal policies would help avoid the procyclical tendencies of the past.

15. Financial sector supervisory framework. A strong, intrusive, and independent supervisory agency is essential to help avoid the build-up of risks that can lead to crisis. In this context, the CBI and FME have put in place a framework to ensure effective coordination. Since last year, the FME has been implementing a second wave of reforms to its organization and business model. Going forward, additional examiners with credit risk expertise may be needed in the onsite inspection area and the credit risk bureau may need more resources to become a powerful supervisory tool. Importantly, preserving the FME’s independence in both reality and perception, and thus also its capacity and willingness to act, is essential to ensure that the needed strengthening of supervision continues, toward full compliance with Basel Core Principles.

The mission is grateful for the warm welcome and excellent cooperation from everyone that it met during this visit.


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